Watch stocks you care about

Shortly after the FDIC took control of Washington Mutual and handed its assets over to the politically well-connectedJPMorgan Chase (NYSE: JPM) , the debt market froze solid. That freezing was a very rational act of self-preservation by bond investors who were financially terrorized by the tyrannical way in which Washington Mutual was seized.

Behind the ice storm was the fact that in the seizure, only WaMu's assets moved to JPMorgan. Many of its liabilities -- including the debts it owed to bondholders -- were left to rot in bankruptcy court. That made a mockery of the concept of Absolute Priority and rendered moot bondholders' claims on the company's assets. That seizure did tremendous damage to the debt market. Until such dictatorial powers are reined in, the lending market simply cannot recover.

Nationalization makes it worseThe core of the problem is simple. Bondholders look for two very critical things when they invest money. First, they want to assure a return of their capital. Second, they want to try for a return on their capital. Whether it's the WaMu way or the Swedish way, if bondholders lose their ability to attempt to recover their capital in a seizure, they've lost all incentive to loan again at anything below usurious rates.

Think about it this way. With good credit and decent income, you might be able to get a 30-year mortgage on your home for about 5.27%. A three-year car loan could run you closer to 6.91%. A loan on your credit card would likely cost you over 10% annually if you don't pay it in full every month.

The only reason banks will offer you that low rate on your mortgage for that long a period of time is because it's secured by the value of your home. If you don't pay, the bank forecloses. Or at least it used to, until Uncle Sam stepped in to help. When the government takes away bondholders' claims on a seized company's assets, it converts those bonds from loans secured by bankruptcy recovery rights into the equivalent of unsecured credit card loans.

Let's face it. These days, nobody other than Federal Reserve Chairman Ben Bernanke is willing to lend money at cheap rates on a mere promise to repay. The government froze the private debt market by the way it mishandled Washington Mutual. Nationalizing the banks without protecting their bondholders will turn that freeze into permafrost.

In Chapter 11 bankruptcy reorganization, a business can keep operating, and bondholders retain their claims on a company's assets. If the company successfully emerges from Chapter 11 bankruptcy, those bondholders are made mostly whole, either through repayment of the debt or the receipt of newly minted stock. And if the company doesn't emerge successfully, then Chapter 7 bankruptcy assures that those bondholders receive as much as practical from the liquidation.

Either way, bankruptcy will do a much better job of helping the debt market thaw out than nationalization ever will because bankruptcy preserves the rights of bondholders.

If the government wants to help reduce the panic and stave off bank runs, it can announce that the FDIC will maintain its coverage on insured deposits at bankrupt banks. Even that help would only be temporary, as it could stand in line ahead of other creditors to be made whole in a bankruptcy proceeding.

Success through reorganizationBankruptcy does not automatically mean the end of the world. Chiquita (NYSE: CQB) lived through bankruptcy and continues to operate its global produce business. Sears Holding (Nasdaq: SHLD) was formed when K-Mart, itself newly emerged from bankruptcy, gobbled up Sears. Delta (NYSE: DAL) is now the world's largest airline, even though it got out of its own bankruptcy less than two years ago. Even Winn-Dixie (Nasdaq: WINN) managed to survive its reorganization process, in spite of the sorry state in which it kept some of its Thriftway stores.

If the government's goal is to help the debt market -- and by extension, the overall economy -- recover, assuring an orderly and controlled bankruptcy process for failing banks would be a great first step. As politically expedient as nationalization might be, the bone chilling effects that poorly executed seizures would have on the debt market would make the recession we've lived through so far seem like child's play.

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment icon found on every comment.

Great article! There are many people who think the take over of WaMu was done when they were solvent. I think I heard at least 8% solvent which is no where near the number in which a bank should be seized. However, I don't have a link for this info. I am glad someone is looking into this more. I am sure if more digging is done, even more could be found out about the fraudulent and hasty takeover of WaMu.

Sorry, this is foolish nonsense. I AM one of the WaMu bondholders who got the shaft from the government in order to "save the world". That transaction was complete *fiction* and quite a SWEETHEART deal for JPMorgan, eh??? Oh well, serves me right for trying to invest some supposedly needed capital into the bank for a modest profit (90/100 is not exactly usurious for a bank that was only "a little" in trouble, is it?) Now I don't have any mercy for any bondholders of any other banks who didn't already get out months ago when they had the chance to figure out that the government was NOT going to bail out every bank (and frankly, let's face it, it CANNOT).

The only answer is to let the FDIC take over the failed banks, RTC them or whatever, and wipe out the equity holders and the debt holders! Credit markets won't truly begin to clear until all the rot is out of the system DUH

Nationalization would probably be a better process if we could trust the gov't to do it correctly. Since we can't trust them, make the fed step back and allow the companies to bankrupt. the sooner the better!

The former Fed chairman said temporary government ownership would ”allow the government to transfer toxic assets to a bad bank without the problem of how to price them.”

But he cautioned that holders of senior debt – bonds that would be paid off before other claims – might have to be protected even in the event of nationalisation.

”You would have to be very careful about imposing any loss on senior creditors of any bank taken under government control because it could impact the senior debt of all other banks,” he said. “This is a credit crisis and it is essential to preserve an anchor for the financing of the system. That anchor is the senior debt.”

There is a much bigger (and hidden) agenda being played against the middle and lower class in this country. If we dont stand up and put a stop to this illegal activity by our govt, one day we will wake up in a third world country with no freedom left.

My suggestion for you, call your elected representatives and tell them that the actions being taken by our govt are illegal and immoral. The Govt works for us. Not the other way around. Sounds like the idea for a (second) Boston Tea Party is looking pretty attractive.

Just remember, Statism is never an answer. And all the good intentions in the world will do little to protect the middle class after all our money and freedom is gone. Our founders would be rolling in their graves if they knew about the criminal activity being committed against middle and lower class American citizens.

How many banks own bonds and/or stock in other banks? A lot. Throw in what Saudi, Dubai and China own in our banks and you will end up with a catastrophic domino collapse if C, BAC or any other "to big to fail" bank is taken out by BK or the FDIC.

Putting Bank of America and/or Citi through bankruptcy is nothing like Chiquita or Sears. That's like comparing apples with bananas.

The large banks are not hedge funds that made bad bets and should "orderly liquidate". They service millions of people, retail and business alike. Their role in our economy is too important to fail. And pray tell, who is going to bid on the trillions of dollars on their balance sheet in BK court?

Chapter 11 re-org is theoretically possible, but the bankruptcy stigma is 10x worse for a bank than for GM or Chrysler. Would I buy a car from a bankrupt company? Debatable. Would I bank at a bankrupt bank? Not a chance. That way lies madness, as hundreds of billions are withdrawn and placed under mattresses.

My point is, there is no easy solution. One cannot say definitively that bankruptcy is the right choice, or nationalization is the right choice. Likely, a mix of the two, with a dash of creativity, and a lot of time, persistence, and pain, are what will see us out of this mess.

So the seizure of WaMu had a chilling effect on the debt market, but the Chapter 7 liquidation of Lehman had no effect? If I remember right, Lehman's bondholders were hit pretty hard (we're talking about 30+-to-1 leverage ratios), and as well it should be. These people loaned money, as adults, to an insolvent company. There is a penalty for that in the real world. It's tough for me to imagine a solution to this mess that doesn't involve bondholders getting whacked.

I'm with ricedawg. No easy solution here. Anyone who says they "know" that this idea is great or that idea is terrible is kidding themselves. Unfortunately, admitting ignorance doesn't get people to read your column. Tough spot to be in.

On Thursday September 25th 2008, Washington Mutual Inc aka WaMu Inc. or WMI or WaMu, common shares trading under the symbol WM, opened at $2.62, rose to $2.69 within the first hour, and then fell on average for the rest of the day and closed at $1.69. In after hours trading it fell to $0.16. Take note it fell 90.5% just in after hours. During the regular day it fell 35.5%. For the entire day it fell 93.89%. All these percentages are based on the open, and excluding the pre-market trading data, which I do not have. For the day, the DJIA rose 196.89 points, and closed at 11,022.06

Clearly anyone who held WaMu through the day experienced a financial wipeout in their position. What caused this wipeout? In a statement issued on the night of September 25th the Office of Thrift Supervision (OTS), an office of the US Treasury, said “An outflow of deposits began on September 15, 2008, totaling $16.7 billion. With insufficient liquidity to meet its obligations, WaMu was in an unsafe and unsound condition to transact business. The OTS closed the institution and appointed the Federal Deposit Insurance Corporation (FDIC) as receiver. The FDIC held the bidding process that resulted in the acquisition by JPMorgan Chase.” (link). WaMu had been seized and sold.

Washington Mutual Inc was a bank holding company and owned two banks, the Washington Mutual Bank, Henderson, NV and a subsidary of that bank, Washington Mutual Bank, FSB, Park City, UT. The first mentioned bank was the main banking operation, and the focus of everyone's attention. Both banks received the same treatment simultaneously on September 25th, 2008 and for brevity they are usually referred to singularly as the Washington Mutual Bank aka WaMu Bank or WMB or WaMu. For the rest of the text this convention will be followed and they will be referred to as one enterprise and principally referring to the vastly larger Henderson NV incorporated bank.

Just seventeen days earlier, on Monday September 8th, with the announcement of the placement of Alan Fishman as the new CEO for WaMu, WaMu simultaneously announced (link) that they and the OTS had negotiated a Memorandum of Understanding concerning aspects of the bank’s operations. It concluded with this sentence. "The business plan will not require the company to raise capital, increase liquidity or make changes to the products and services it provides to customers." Alan Fishman had recent successful experience with merging banks he was in charge of, and his employment and hefty salary were seen as an indication WaMu was setting itself up for a merger.

WaMu had suffered a rush of withdrawals and thus draw downs in its liquidity that the regulators at the OTS and FDIC said they felt justified a seizure of the bank. The accounts that withdrew were mostly large retail accounts of over $100,000 which at the time was the FDIC insurance maximum. These accounts were used primarily for payroll purposes. Mostly these accounts were in California, where the memory of the IndyMac bank seizure was likely on their minds. The speed and amounts withdrawn do not qualify as a bank run, as a bank run is a complete wipeout of deposits over a few days. At most it could be characterized as a walk on the bank. The withdrawals were done by electronic banking over the internet and by wired funds. It was not in the news, people were not lined up outside the bank. WaMu was the largest thrift in the nation, and the sixth largest bank by deposits. They had 2,239 branches in 15 states, concentrated in the west and south. They were large enough that the Federal Reserve assigned them onsite full time bank inspectors to monitor, among other things, liquidity levels. The Federal Reserve was witness from beginning to end of the liquidity draw down.

A walk on the bank, is a mild form of a run on the bank. Bank runs were typical of the great depression which started in 1929. Customers want their cash in their hand, because if a bank dies and locks its doors, their cash will be forever beyond their reach. Bank runs have an effect on the public and the government that tends to snowball and be a self fulfilling prophecy. If a new bank has a problem, because a bank run has happened recently, it may be happening again now, so they do a run on that bank etc. Bank runs close banks down, and draw their cash down to zero. A slew of bank runs that closes banks is known as a bank panic.

In response to the bank panics of 1929 and the early 1930's, in 1933 the government created the Federal Deposit Insurance Corporation (FDIC). The FDIC is a government corporation that provides insurance on bank deposits. At the time of the WaMu seizure the insurance covered up to $100,000. In large part due to the WaMu catastrophe the FDIC has implemented a temporary increase in the amount of insurance on deposits, and it is now $250,000 until Dec 31, 2009, unless extended. The Chairman and four Board of Directors of the FDIC are all appointed by the President and confirmed by the Senate, with no more than three being from the same political party. The FDIC is self funded through its insurance premiums, which are paid by the banks, and it has an immediate $30 billion line of credit with the US Treasury, and procedures are in place if more credit is needed. From 1996 - 2006 the FDIC waived the collection of these insurance premiums as it was at the upper limit of its legal reserves. The point of FDIC deposit insurance is so that even if a bank locks its doors, your deposits are covered up to the insurance maximum of $100,000, and for now $250,000. The idea was this would prevent the demand side, that being depositors, from doing bank runs.

The Federal Reserve system was created in 1913. The primary reason for creating the Federal Reserve was to prevent bank runs, from the supply side, the running out of cash at the bank, which had been a problem, causing bank runs, in the recession of 1907. The mechanisms to do this are by the banks loaning liquidity to each other in a process called Federal Funds, which is short for Federal Reserve Funds. Then there is a process of a bank borrowing straight from the Federal Reserve called the Discount Window. The Federal Reserve is a private corporation composed of the biggest banks in the country, who form the stockholders of the Federal Reserve. The Chairman and the six Board of Governors of the Federal Reserve are all appointed by the President and confirmed by the Senate. This is the legal extent of the Governments involvement with the Federal Reserve. Thus the government has weak control over the actions of the Federal Reserve. All banks in America are members of the Federal Reserve System and all paper money is printed by the Treasury per the amounts ordered by the Federal Reserve. All electronic money, wires, credit cards, debit cards etc and all check book money, is also under the monetary policies of the Federal Reserve. The Federal Reserve controls how much money, (cash, electronic, check book,) banks have on hand through its regulations and membership requirements. It maintains this flexibility so that it may meet the liquidity demands of banks.

WaMu was the largest thrift in America and part of the Federal Reserve System. WaMu had some no pay and slow pay mortgage loans, like many banks in America today. These loans were not an overwhelming problem for WaMu, as they had cash reserves enough on hand to last two years at the current bad loan rate.

After the Dot Com bubble burst in 2001, the Federal Reserve lowered interest rates to make borrowing more attractive, to stimulate the economy out of the crashing caused by Dot Com companies going out of business. Home loans became a primary source of lending customers. Competition was high and banks lowered requirements to receive loans, to make business and to get as big a share of the business as they could. The least stringent home loans were known as subprime loans, as they were made to other than prime customers. Often the loans were structured with low payments up front, and higher payments in the later years. Often these mortgages were sold to other lenders after they were written, and WaMu had purchased a lot of their mortgages. Over the years some subprime customers lost their ability to make their payments on time. As payments rose some borrows could not pay.

A bank’s assets are its loans, because loans are where people owe you money plus interest, an income stream. Deposits are a liability, because the bank owes the depositor the money, plus interest, and is liable for its payment on demand.

Insolvency is when a person or company can not meet the current obligations or payments on their debts, using whatever capital means they have available to them. WaMu borrowed money from citizens like all banks in many forms, Cds, secured bonds, unsecured bonds etc. to get money to do its business. WaMu was perfectly able to make the interest payments and redemption payments on its debts. WaMu was not an insolvent or bankrupt bank. WaMu held a lot of small deposit accounts, and depositors make withdrawals, thus liquidity, having funds available on hand for withdrawals was WaMu’s primary concern.

Bankruptcy is a courts legal recognition of a company's insolvency. There are three types of bankruptcy, Chapter 7 liquidation, Chapter 11 reorganization, and Chapter 13 which is a personal bankruptcy.

Liquidity is when your cash on hand and current income stream is able to meet or beat your current debt service and other liability requirements, without having to sell assets. As subprime loans fail to pay, a bank is losing its income stream, or it is losing its liquidity, as the monthly checks are not showing up. Less money coming in means less is available to pay the monthly interest to bond holders, Cds, savings deposits and also for customer withdrawals and redemptions etc. WaMu’s liquidity was shrinking due to its subprime loan failures, but it was not at a problem level, and WaMu was seeking solutions. In March 2008, JPMorgan Chase offered to buy WaMu for $8.00 a share, hoping the bank would accept it as a way out of its liquidity crunch. WaMu declined and instead on April 8th took a seven billion dollar cash infusion, two billion from an investment firm TPG Capital, in trade for 822,857 new common shares at $8.75, with the remainder preferred shares convertible to common shares, and five billion from other investors in trade for new common shares. Total new common shares issued at the onset of this deal being 176 million, and more created when the preferred shares converted. See Note 9 on the bottom of page 21 here. David Bonderman the CEO of TPG had been on the WaMu Board of Directors from 1997-2002. With this new deal he once again became a member of the Board of Directors. Another part of the deal was that WaMu had to accept an anti-dilution clause wherein if WaMu sold itself, or issued new shares worth over $500 million, for less than $8.75 a share, within the next eighteen months, TPG would be paid the difference against their shares. Shareholders disliked this whole deal, but they approved it to avoid stiff built in penalties. Although this cash infusion helped, there was a liquidity problem for WaMu in July 2008 when IndyMac failed. In September 2008 WaMu made the decision to find a buyout partner from a bank with better liquidity so the merged bank would have adequate liquidity in the face of a growing credit crunch. On September 8th they hired a new CEO Alan Fishman. On September 17th they announced they had chosen Goldman Sachs as a broker to find a buyer and work out a deal. On this same date TPG waived its anti-dilution clause to help facilitate the sale of WaMu. There were five to seven major banks interested, including Banco Santander, Citigroup, HSBC Holdings, Toronto-Dominion Bank, Wells Fargo and JPMorgan Chase again.

Other banks were in a similar situation. Congress under pressure from both the Federal Reserve and the Treasury was being urged to authorize government funds to bailout the banks with the subprime loan failures and thus the increasing liquidity problems. The idea at the time was the government would create new government obligations, bonds of various term lengths, and swap these for the banks’ subprime loans. As the government has the ability to control tax revenue by increasing taxes, its ability to pay its debt obligations is the highest you could have, because it can and does enforce the payment of taxes. If it needs money to pay a debt it increases taxes. The government would put itself in charge of collecting the subprime debts as well, and defaults are more easily absorbed by them as they are also offset by its tax collecting abilities.

The bailout swap plan would insure the banks current income streams would increase as all payments would be made, and also be quite certain going forward as the government is not likely to go out of business. This plan is essentially the $700 billion bailout plan that was being discussed in Congress at the time. This plan would strengthen WaMu considerably, and even to the point where some were speculating WaMu would not have to sell and could continue on as an independent bank. It also made WaMu and all the banks a much better investment or merger candidate as much more of the portfolio value and income streams would be certain, and known. In the first week Goldman Sachs had been unable to find WaMu a buyer. The one huge obvious problem was the bailout talks and what their results would be, and the end effect that would have on the income value of WaMu's loan portfolio. There was another problem too though. Unknown to anyone the FDIC had already been offering WaMu secretly to the same potential customers that Goldman Sachs went to, but as a branches, deposits and loan portfolio only sale, free of all financial obligations to bond holders and of all claims of shareholders, to be done by private auction, and implemented by a WaMu bank seizure. This had killed WaMu's chance to find a buyer from another bank, and WaMu was now talking to two private equity firms, the Blackstone Group and the Carlyle Group, to see if they would be interested in buying the bank.

WaMu’s average account was only $5,200.00, well within the FDIC insurance range. In aggregate these FDIC insured accounts were much more in dollars then the FDIC had in cash to pay insured depositors. Since if it ever came down to it, the FDIC would be unable to make good on its insurance plan, without borrowing from the Treasury, the FDIC had offered outwardly to help Goldman Sachs in brokering a deal for a buyout of WaMu. As soon as the rates being received for the subprime loans in the bailout was known the banks could then establish a value and price for the bailed out WaMu. This makes sense, and this is what investors were told and thought, but the majority of the prime customers already knew WaMu was to be seized and auctioned, and for that to work it had to occur before the bailout. It was not WaMu that had the liquidity problem, it was the FDIC that had the liquidity problem, and the FDIC chose to protect what little liquidity they had by preemptively and unjustly seizing WaMu. The FDIC decided to avoid any chance of being caught short of cash, and used their regulatory powers to transfer their cash problem onto the WaMu shareholders and debt holders by wiping out their investment positions.

The White House and Congressional Finance Committee members began discussing the bailout together from my memory on Wednesday September 17th, the same day that WaMu announced that it was for sale. The actual Congressional hearings were started the next day, and were held everyday thereafter. The bailout, now known as The Emergency Economic Stabilization Action (EESA) of 2008, was passed Saturday October 2nd and made law on Sunday October 3, 2008. The first and only implementation of bailout funds so far was the purchase of preferred shares in twenty-five US banks. This was a bailout technique that England had recently used for their credit crisis.

Just previous to the initiation of the bailout proceedings, due to falling stock prices in financial issues, and most of the banks, for the entire year, thirty day bans on short selling were introduced. The first one announced Tuesday July 15th was on nineteen finance stocks, and solely a ban on naked short selling. Kerry Killinger then CEO of WaMu had asked Treasury Secretary Henry Paulson to put WaMu on that list, but he was denied. On Wednesday September 17th naked short selling was banned on all stocks, and on Friday September 19th all short selling of any kind was banned on 799 finance stocks, and this was good until Thursday October 2nd, and has since been expanded and extended. WaMu was on the list of 799 finance stocks. All short positions on the 799 stocks had to be closed out within three days, and thus be covered by the market close of Wednesday September 24th. Shorts sell stocks at high prices and buy them at low prices and profit the difference. It works best in downtrends, which defines many bank stocks for the year. As this short selling ban relieved some of the selling supply at high prices, it was hoped with less supply, there would be dearer demand and prices would rise. There is though the other angle to this which is when stocks drop, shorts buy, creating demand at low levels and slowing and reversing descents. It is interesting to note that there was little short covering in WaMu, thereby disobeying a SEC order, and that the bank was coincidently seized the day after all shorts should have been, but were not, covered. It has now been revealed that most shorts have covered since the crash and paying pennies a share to do so.

On Thursday September 11th WaMu provided an Update on Expectations for Third Quarter Performance (link), with the official results scheduled for Wednesday October 22nd. This is part of their release, "The company expects its capital ratios at quarter-end to remain significantly above the levels for well-capitalized institutions and continues to be confident that it has sufficient liquidity and capital to support its operations while it returns to profitability. Net interest income is expected to be in line with the second quarter. The third quarter provision for loan losses is expected to be approximately $4.5 billion, down from $5.9 billion in the second quarter while reserves are expected to build, as described in greater detail below. Net charge-offs are expected to increase by less than 20 percent in the third quarter compared with a growth rate of nearly 60 percent during the second quarter. Non interest income is expected to be approximately $1.0 billion, up significantly from the second quarter, reflecting continued growth in depositor and retail banking fees (up 6% from the second quarter) as well as stronger MSR results due to slower prepayment speeds. Non interest expense is expected to be down approximately $200 million, reflecting expectations for lower resizing costs and lower foreclosed asset expense." It also had this to say about its Liquidity and Capital Retail deposit balances at the end of August of $143 billion were essentially unchanged from year-end 2007. In addition, the company continues to maintain a strong liquidity position with approximately $50 billion of liquidity from reliable funding sources. The company's tier 1 leverage and total risk-based capital ratios at June 30, 2008 were 7.76%, and 13.93%, respectively, which were significantly above the regulatory requirements for well capitalized institutions. The company expects both ratios to remain significantly above the levels for well-capitalized institutions at the end of the third quarter.

In general things were the same or better than the previous quarter. The worst thing was the small detail that deposit levels had not increased since the end of 2007, which was not a big deal, considering possible benefits from the bailout and also especially a buyout, once the bailout details were known. Note both capital and liquidity were well within acceptable limits.

On Monday September 15th Standard & Poors issued a downgrade of some of WaMu's bonds, but made this positive statement about their liquidity. " WAMU's overall liquidity profile at the bank and the holding company is positioned to withstand this weak credit cycle through the end of 2010. During the past year, WAMU has conservatively and prudently managed its holding company liquidity position. It faces minimal debt maturities through the end of 2009. WAMU reaffirmed that its outstanding debt is not subject to rating triggers or other terms that would cause acceleration."

Also on September 15th, Lehman Brothers, the fourth largest investment bank in the US, declared Chapter 11, bankruptcy reorganization. Lehman Bros was not a depository bank. It was a first in a major Wall St firm declaring bankruptcy in recent memory. Bear Stearns another large investment bank had in March 2008, come close to bankruptcy, but the government worked out a dealfor them where JPMorgan Chase ended up purchasing Bear Stearns. The Lehman Bros bankruptcy put everyone on edge.

On September 18th Alan Fishman the new CEO released a letter (pdf link) to shareholders in which he stated "Capital ratios describe the financial strength of a bank. Our ratios continue to be well in excess of the levels that government regulators require of “well capitalized” institutions. We also have an ample supply of funds on hand to meet your needs and the needs of our other customers and our day-to-day operations." That the WaMu bank was well capitalized has never been disputed and the OTS in a Fact Sheet (pdf link) they issued on WaMu on September 25th 2008 said "WMB met the well capitalized standards through the date of receivership."

Thus going into the week of Thursday September 25th for WaMu there were expectations of large short positions covering and a possibly beneficial outcome to the bailout meetings, and regardless, shortly after a buyout merger. The total amount of outstanding shares short was 26% of the float, or about 420,000,000 shares. Who were these shorts? Did JPMorgan Chase have a large short position, did Citigroup? The three credit ratings services all gave WaMu debt downgrades during the week, first by Moody’s on Monday September 22nd, then Fitches on Wednesday September 24th and finally Standard & Poors on Wednesday evening September 24th. Essentially they were all downgrades from junk to junkier. Some people saw this as window dressing being done before the bailout was passed, and that it was being done so that whatever plans the bailout came up with, the debt would be freshly rated for carrying out that decision making. Many did not see it as a panic situation for this reason, and when one service down grades you, the others always automatically follow.

One issue of the bailout meetings was the rate at which the government would swap for the subprime loans in the plan then under discussion. Should it be the hold-to-maturity value, ie the full anticipated value when issued for its maturity or some reduced or discounted value, particularly the current market value, known as mark to the market, as determined in their distressed current condition and its effect on their current trading levels. Both Federal Reserve Chairman Ben Bernanke and Secretary of the Treasury Henry M. Paulson, Jr., were quite clear and stressful when speaking publicly about this that the subprime debt should be purchased at hold-to-maturity or full value to adequately capitalize the income streams and liquidity to the receiving banks so that they would be in a strong position to generate business at the local levels and keep the economy from slipping into a recession. They also stressed for similar reasons that the bailout should insure that no large banks fail, and that numerous small bank failures would not be acceptable either. WaMu was the largest thrift in the nation and all indications were that it was a prime candidate to succeed from the bailout. WaMu though made it clear that if a buyout was not completed before the bailout they would continue to look for a buyer in any case. As events unfolded the sincerity of those that made remarks concerning no large bank failures has to be questioned, and it has to be questioned if they were deliberately misleading the investing public. In general bank share prices drifted downward as the bailout meetings got underway. There was bickering, Pres. Bush invited both Senators McCain and Obama to a White House meeting that ended chaotically. I personally was unable to watch the hearings on TV, but those who did, did not seem inspired. The expected short squeeze in WaMu from the SEC ban on shorts in financials had not materialized. It should have taken seven days at recent typical daily volume levels for the number of known shorts to cover. Volume levels for the 22nd, 23rd and 24th do not show this short covering. There was higher volume on the 25th, but not enough for the shorts to have covered, and this volume was all related to the sell off from that days seizure talk and actual seizure. If JPMorgan Chase or Citigroup or their confidents had been a major shorter of WaMu they had not covered. Strangely the SEC and no one in government has had anything to say about this. Wednesday evening September 24th President Bush gave a televised speech to the nation on the economic problems and the bailout. One remarkable statement he made was that the subprime debt would be purchased at current market, very depressed, prices. This was the exact opposite of what the Federal Reserve and the Treasury had been saying. It also seemed to contradict the purpose of doing a bailout. Thursday September 25th was in general a day bank shares drifted down and the hearings produced no results. WaMu's stock began falling within the first hour, and this was attributed to the downgrades of the previous day and evening. I worked that morning, and was not at my computer until after the regular trading. I do not watch CNBC either, but during the day CNBC reported they had leaked information that WaMu would be seized by the FDIC as a bank failure. They did not report a source for this leak. This leak accelerated both the large retail online withdrawals of deposits from WaMu and the falling stock price for the day for WaMu. WaMu’s stock fell almost a whole dollar and 35% for the day. I remember getting home in the early afternoon west coast time, and the market had just closed. I was taken aback by the dollar drop for the day. Looking on the message boards I thought I understood the sellers concerns, but believed that the government would prevail, no one mentioned a seizure. This was the mindset that week, in fact Warren Buffett considered one of the best investors going, had late Tuesday September 23rd bought $5 billion dollars of Goldman Sachs stocks for essentially the same reason. As by now all shorts were supposed to be covered and out of the market, even though there was no evidence this ever happened in WaMu, the steep fall in price was being partially understood as due to this normal braking mechanism to the market having been removed. I looked at an early after hours quote and it was a few pennies from the regular market close of $1.69. I surfed onto some nonfinance things. To me it was less than an hour later when I checked back again and the quote was $0.52. A drop of another dollar and two dollars for the day. I went to the Yahoo WM message board and began looking at posts. Some people were up in arms, some people said it was oversold panic selling etc. I stayed and watched the posting and began reading news sites for news. First there were posts on WaMu closing. This made no sense. I saw a post where the word seized was used. It had only one news source anyone could find backing it. I was unaware of CNBC’s earlier reporting in the day.

WaMu’s price by now was at about $0.16 where it would close, though it did go as low as $0.09 from my memory. It was discussed what they meant by seized. At about this time after hours trading ended. There was a strange spike in the final minutes of trading when someone bought 272,000 shares at $1.69, the regular market close and ten times the current price. This has never been explained, some suggested that someone on the inside had gotten trapped in the avalanche after hours and was rescued by his bank buddies at the end, others think someone just mistyped a buy at market order, leaving off the leading zero. As soon as after hours trading had closed there was suddenly a storm of news stories about the seizure and we learned the following. Most investors understood that Washington Mutual Inc was a holding company trading under the symbol WM and that the holding company was the owner of the Washington Mutual Bank. The shares were shares of the holding company, not the bank. Many banking companies are set up this way and here is a list of the top fifty bank holding companies. The OTS and FDIC recognized this as well and chose to exploit this corporate structure. Without a public word they realized that the WaMu bank could be seized and that the shareholders and debt holders of Washington Mutual Inc. would lose the primary asset of their company, but that their claims would not be directed at them for the possession of the asset, but rather would be directed at the holding co, who they owned shares in. Had everything been exactly the same for the WaMu Bank, but that the shares and debts been in the bank’s name and not the holding companies, it is likely the bank would not have been seized. That the corporate structure allowed a loophole to screw the shareholders and debt holders is really the reason the WaMu bank was seized. At about 7:00pm JPMorgan Chase announced they would be holding a Conference Call at 9:15pm. The conference call was used to announce to the world they now owned WaMu. JPMorgan Chase also released this press release that evening, and later this presentation (pdf.link).

JPMorgan Chase is one of the primary stockholders of the Federal Reserve which means they have the power to force favors from the Federal Reserve. The CEO of JPMorgan Chase, Jaime Dimon, sits on The Board of Directors of the Federal Reserve Bank of NY. Citigroup is also a stock holder of the Federal Reserve. It is the Federal Reserves job to insure that its member banks have the liquidity to transact business. The member banks borrow and lend among themselves electronically every night to keep each other liquid. This is called the Federal Funds. If need be a bank can also borrow directly from the Federal Reserve itself through a process known as the Discount Window. The FDIC was in a jam in that if WaMu was ever deprived of funds from the Federal Reserve, say for fear of not being paid back, and a bank run ensued, the FDIC would not be able to cover the insured deposits without borrowing from the Treasury. There is some slight differences in the amount the FDIC would have had to cover. Some estimates leave the FDIC with a nominal balance. Apparently the thought of having to borrow funds from the Treasury so early in the credit crisis was considered too much of a defeat for the FDIC to be comfortable with. Unknown to anyone in the public the FDIC was working on a secret solution deal. On one hand they were talking with WaMu about helping them find a buyer and the valuation of its loan portfolio, and secretly on the other hand they were allowing JPMorgan Chase and the other banks to have complete access to the books of WaMu and were offering to seize the bank and sell it to them in a private auction, which would free the purchaser from all liabilities to the debt holders, and all claims from shareholders. This would get the FDIC out of their jam. The words Toxic Paper, Toxic Debt, Toxic Loans etc suddenly were all over the newspapers and the internet. The idea that the FDIC’s cash balances could not make good on its insurance liabilities was being well advertised, but their credit line and credit abilities with the Treasury were seldom mentioned. Though borrowing from the Treasury would make the FDIC solvent, accounts over $100,000 would still lose everything above $100,000. These accounts read the writing on the wall and began silently electronically removing their funds from WaMu. As mentioned the Federal Reserve inspectors would be on hand to witness this day by day. WaMu’s cash on hand and hence liquidity was being drawn down. Did the Federal Reserve step in and loan them this liquidity as the system is set up to do for just these type of incidents. No they did not. Was the reason because WaMu still had plenty of liquidity left, or was there some cooperation going on between the Federal Reserve, the FDIC and the Treasury? This all occurred as the Congressional bailout meetings were underway.

Once the bailout was completed, the plan being discussed, would have WaMu’s bad subprime loans swapped out for good government paper, maybe some at 100%, maybe some at a discounted level, maybe some at market level. WaMu’s improved condition in any case would make it a much more solid purchase after the bailout then before. WaMu was being set-up in a triangulation of cross fire, between the Federal Reserve, the Treasury Department's OTS, and the FDIC, to affect a seizure and a fire sale at auction. The beneficiary’s of this would be the FDIC, which would be removed of the potential problem of having to go into debt to the Treasury if it ever needed to pay the insurance on WaMu's deposits, the Treasury which would now not have to considering ever loaning the FDIC any money to cover the deposits, and the big winner the Federal Reserve/JPMorgan Chase which ended up owning WaMu, its loan portfolio, and deposits, and its jewel of branch networks, free of all debt holder obligations and claims of shareholders.

There is also the consideration that JPMorgan badly needed the cash from the deposit base of WaMu to help shore-up its very leveraged derivatives trading transactions. JPMorgan's acquisition of Bear Stearns, also done with the government's help, was said to be have been done for this same reason. If JPMorgan were ever unable to fulfill their ends of their derivatives trades, and collapse, it is thought it likely would bring down all of Wall St and the economy. Some of these trades were with WaMu and these trades would self cover and cancel, just as it was done with their Bear Stearns trades. Thus the actions of the OTS, FDIC and Federal Reserve may not be entirely about money, but also about their reputation and their performance of duty, and that they chose to kill off WaMu to save their own necks by helping to save JPMorgan's neck. WaMu’s parent company Washington Mutual Inc shareholders and debt holders though were forced into taking an unjustified catastrophic and total loss.

Thus the Federal Reserve watched WaMu, while knowing their own stockholders, JPMorgan Chase and Citigroup, were participating in secret backroom discussions with the FDIC wherein it was decided the Treasury Department's OTS would seize WaMu for "lack of liquidity" and give it to the FDIC who would have it auctioned off in advance. Included would be the branches, deposits, and the loan portfolio including subprime mortgages, which were eligible to wash off as a write down to the final amount paid, and what was not written down and washed off, would be eligible for swaps under the bailout plan. All for a fire sale private auction price, and leaving WaMu Inc the holding company hanging onto all the obligations to the bond holders, as well as all the obligations to the preferred shareholders, and all claims by common shareholders. The winner, at $1.9 billion was JPMorgan Chase. JPMorgan Chase was able to take a $31 Billion write down on the subprime mortgage loans as part of the deal, even though WaMu had previously calculated $19 Billion as the bad loan amount. The unsecured mortgage loans JPMorgan took and could not write down are still eligible for the federal bailout plan. JPMorgan also got the WaMu bank branches throughout the west and south they had wanted so badly. If JPMorgan Chase or any of the other banks in the secret dealings had major short positions, they had not covered. When WaMu’s stock price collapsed after the seizure, they could cover for cheap, or maybe just be able to hide the fact. When a company declares bankruptcy shorts do not have to cover - it is game over. That a lot of the shorts never covered in WaMu and that certain large banks were privy to the FDIC’s plan to seize and close the bank, would make it simple for these banks, their friends, confidants, and all their proxies, to never cover their shorts and keep a large profit. This would help cover a lot of bad derivative trades and may be why it is not being discussed. That nothing has been written about this makes it even more likely this is what happened. This would be insider trading, an illegal act. As Congress discussed the bailout on Thursday September 25th, and after regular market hours, the OTS seized control of WaMu, and turned it over to the FDIC who immediately turned it over to the auction winner JP Morgan Chase. This was announced after all trading had ended simultaneously as one single packaged story. Bank seizures are traditionally done on Fridays so the weekend can be used to sort out the paperwork and details. Investors planning to watch WaMu's Friday trading action and planning to decide whether to hold or not considering a possible Friday seizure were robbed of the opportunity. The OTS/FDIC said they chose Thursday because of the leaked seizure report being circulated, and thus imply that a very real potential, a final agreement to the bailout meetings on Friday, was not a consideration. They say they feared the leak would increase the rate of withdrawals leaving WaMu that Friday. This has to have been one of the most valuable leaked reports in American history and one wonders if those who benefited so handsomely from it may have also been those who started it. As a further deflection, although a loan swap had been sold to everyone as the bailout all along, the Treasury pulled a surprise on everyone after the bailout was passed and did a preferred stock purchasing plan instead. Was this to distance themselves from the WaMu take down and modus operandi behind it?

JP Morgan Chase had at least three weeks to prepare their bid, during which time they had at least seventy-five of their own people crunching numbers and working forecasts, using the data WaMu had supplied to the FDIC under the understanding that the FDIC would help them facilitate a buy-out merger transaction. Bids were submitted on the 23rd and the FDIC notified JPMorgan Chase they had the winning bid on the same day. The $1.9 billion was paid to the FDIC, who say it will be used to toward paying off the debt holders.

J.P. Morgan becomes the country’s largest bank by deposits, with more than $900 billion in deposits, and second largest overall. They added WaMu's 2,239 branches in 15 states, many in key states where they had little or no presence, like California, Oregon, Washington and Florida and becoming stronger in states where they were low and mid level players, like Texas, Colorado, Utah and Illinois.

J.P. Morgan acquired all of the assets, all of the bank branches, and all of the deposits of Washington Mutual Bank and nothing of the holding company’s Washington Mutual Inc. Washington Mutual Inc retained only the senior unsecured debt, subordinated unsecured debt, and preferred and common stock. Due to the seizure, the next day Friday September 26th Washington Mutual Inc filed for Chapter 11 bankruptcy, a reorganization, and listed assets of $32.9 billion, and total debt of $8.2 billion. Much of the assets were shares of the seized bank valued at the preseizure price.

A little needs to be said about bank deposits. To a bank, bank deposits are a liability because the bank owes the money, plus the interest promised, back to the depositor. This is obviously true. What needs to be considered is that the banking system is based on fractional reserves. When a bank receives a thousand dollars in deposits it gets to lend out, most of the money, at a higher interest rate than it pays depositors. In the USA the reserve requirement is about 10% (10.3 actually). The bank receives say a thousand dollars, promises 2.5% on it, loans out $900 and receives 7.5% on it, and keeps the difference. If money the bank has loaned out, is redeposited back into the bank, they can repeat the process with that deposit. Banks make good money off of the deposits. Banks do a lot of advertising and customer service benefits to get people to deposit money at their bank. It is a slow trudging process to build up a banks depository base. When JPMorgan Chase received $188 billion in WaMu deposits, the amount of deposits on the date of seizure, for a $1.9 billion payment, it was a huge steal of a deal. Now consider that to build deposits a bank has to be located in areas convenient to entice depositors to deposit with them. The bank needs a branch network. This is a costly, slow to build, trial and error system that generally takes years and decades to create. It is a highly valuable asset. JPMorgan Chase also got all of the WaMu bank branch system as part of the deal. Also as part of the deal they got to write off all the bad loans they felt WaMu had on its books, $30.7 billion was the figure they agreed to. So their risks were washed away and their benefits were enormous, and they paid a measly $1.9 billion for the deal. It was the WaMu investors who paid for this deal, by receiving nothing for their bank, a total robbery.

The mortgage assets JP Morgan acquired were $176 billion of WaMu’s home loans. Those assets were immediately written down by 19%, or $30.7 billion. Leaving JPMorgan with a cool $145 billion dollars of good assets, some that are eligible for the bailout plan, for which they paid less than $2 billion dollars, and this does not include the real estate assets. The only liabilities they took were the deposits. A few weeks after the dust settled from the seizure it was revealed that WaMu Inc., the holding company, had $4.4 billion dollars in accounts in the WaMu bank. The FDIC is claiming this money in court as part of their receivership. If WaMu Inc, the holding company, had been invited to the secret private auction, and bid the balance of just these accounts, as most people think they gladly would have, they would have won and beaten JPMorgan's bid by more than two times.

JP Morgan expects the deal to generate $12 billion dollars over the next three years, or $4 billion dollars a year, making them a 100% profit on the deal in the first year, and an additional 200% profit every year from then on. Thus the increase in earnings per share will be immediate and is expected to be between $0.50 and $0.70 a year, starting in 2009 and every year thereafter. The owners of the company, the Washington Mutual Inc shareholders, received zero dollars on their shares, and they now trade at around three cents. They had their primary asset preemptively confiscated and sold, for less than two cents on the dollar, which they do not even receive, for the so called reason that it suffered occasional short term liquidity problems and those whose duty it was to help them out with liquidity problems didn’t want to, and the FDIC that guaranteed some of its liabilities didn’t want to take the extremely unlikely and extremely short-term and extremely slight risk that they may need to pay on their guarantees should WaMu actually not be able meet withdrawals before possible benefits from the bailout began and/or a buyer was found and the bank sold off at a fair value. Though simply giving WaMu depositors a temporary increase in FDIC insurance coverage would have been all that was needed to remove this one highly unlikely potential problem. Unless of course they felt some extremely powerful outside force could precipitate this problem. The bailout which at the time was about to be passed in the forth coming week, maybe even the next day, would have possibly eliminated this problem, and the mere completion of the bailout would have cleared away the final unknowns in the way of a buyout merger. Although in reality the buyout option had already been secretly sabotaged and ruined by the FDIC's secret auction agreements, leaving them no choice but to finish with seizing the bank and it would look a lot better done before the bailout was passed. The liquidity problem would have taken weeks or even months to occur even without a bailout and only if the worst happened or a media campaign was done. Yet because of a news leak the OTS justified seizing WaMu immediately before the bailout passed. The seizure and its timing also hugely benefited the brazen uncovered shorts, whomever they were. Washington Mutual Inc and its shareholders were set-up by WaMu's family and friends and then robbed and murdered by them. The whole WaMu take down was accomplished by subterfuge, sabotage, deceit, propaganda, illegitimate seizure, done irregularly, on the sly, in secret, in darkness, under camouflage of smoke and mirrors, on leaked news, and ended solely to the financial advantage of the FDIC, the Treasury Dept, the Federal Reserve/JPMorgan Chase, the uncovered shorts, and those rich enough to keep over $100,000 in their bank accounts. WaMu shareholders were totally wiped out. It is one of, if not the, greatest theft in American history.

To add insult to injury after EESA 2008 was made law on October 3rd 2008 JPMorgan Chase became one of nine banks to receive money from the EESA funds in exchange for preferred shares created especially for this purpose. On October 14th JPMorgan Chase received $25 billion from the EESA funds. In effect the government paid for JPMorgan Chase to take over WaMu and then paid them a $23 billion bonus for doing it. WaMu would not have even needed $23 billion in mortgage guarantees to be effortlessly merged and preserving the shareholders and bond holders investments and the soundness and thus confidence in the US financial system. It was a tragic move by the FDIC.

For those who say WaMu made bad loans and so the deserved to be taken down, it isn't true. WaMu's bad loan rate was 3.62%, that is not enough to justify the trillions of dollars sucked out of the economy by the WaMu catastrophe. Further more JPMorgan Chase is drowning in bad derivative trades, far more than WaMu's bad home loans. It is more moral to make a bad home loan, which leaves a house and a place for someone to live, then it is to lose even more millions in bad derivitive trades which leave nothing but worthless paper. WaMu deserved government assistance more than JPMorgan Chase.

Intriguing article. The cause and effect between Wamu bondholders getting the shaft and subsequent credit freeze needs to be proven more convincingly though. I and I suspect most readers are ignorant here. The spike in mortgage delinquencies around that time makes me very skeptical though. I don’t see how you can make a case that pissed off bond investors somehow caused that.

I’m not sure splitting hairs on what we call nationalization/receivership/bankruptcy is as important as how it’s done.

Bank failures have happened in this crisis and will very likely continue to happen for some time to come. The discussion has long passed the point of "how do we keep the failures from happening?" It's now at the point of "how do we keep the overall economy and financial system functioning during and after the failures?"

And key to the a successful answer to that question is an assurance of the due process rights of bondholders in the event of a corporate failure. That doesn't mean that bondholders have the right to always be made whole, but it does mean that bondholders need to have the right to attempt to collect from the assets of a failed firm.

Because without that right to collect, every loan in essence becomes a signature loan or a credit card loan. The interest rates on those types of unsecured loans are typically far higher than loans secured by either property or bankruptcy priority rights. The outrageous additional costs that would come from those extremely high rates would truly be the death knell to our already damaged economy.

The entire capital market doesn't freeze just because a company -- even a large bank -- is going bankrupt. The capital market freezes when the rules get rewritten unilaterally to destroy the property rights of those supplying the capital.

The market has a mechanism -- known as price -- that keeps it functioning as long as those property rights are intact. Money itself may cost more during a supply shock caused by a major bankruptcy, but money will still flow.

Recall last summer, when gasoline spiked to over $4 a gallon. Other than temporary weather-related supply disruptions, gasoline was still available (albeit at a dear price) whenever you needed it. Yet back during the 1970s era of price controls, gasoline was heavily rationed and often difficult to come by.

It's the same way with money itself. The market price for money is known as an interest rate, and it's set by supply and demand. As long as you don't artifically constrain the supply by trying to force prices too low, there will be enough money to meet demand. Taking away lenders' property rights is the financial equivalent of the price controls from the 1970s.

Great Article. Finally, somebody has explained in very simple language why Government intervention is bad. It is time that we stop supporting bad management with taxpayer bailouts. Let troubled intuitions restructure and become a viable entity or let them fail.

Hhm since HRollers comments are so long that I doubt folks will have the patience to read it, let me point out some facts many seem to have overlooked.

WAMU was both liquid and well-capitalized. (They had access to 54 billion--CASH) The OTS seized them after pressure from the FDIC who was playing the "what if" game. The action was premature. WAMU was not about to fail.

See www.wamucoup.com for tons of info on this seizure. You will be amazed that the OTS and FDIC did what they did and seem to have gotten away with it...so far...

Recently PBS Frontline did a story showing that the "run" was not just a run on WAMU, it was a run on the entire banking system. The OTS made it worse by allowing WAMU to be seized, as it told investors "your money is not safe invested in any bank". Paulson made it worse with the attitude that bankers would have to pay...

Well bankers did NOT pay, they still got their fat bonuses...investors paid, and are still paying. The seizure of WAMU was illegal...they did not meet the criteria to be seized. (Check out the site above and the FDIC and OTS sites)

WMI has filed a claim against the FDIC, and I expect they will either get restitution from the FDIC or the FDIC will be sued for fraudulent conveyance. (Your tax dollars hard at work)

EVEN if WAMU was sinking, the bailout passed days later would have helped it to sell itself for a reasonable price. They had enough cash to get through that time period. Banks did not want to bid on WAMU until the bailout was passed, so they could accurately assess the bottom line.

The FDIC minimum bid on the auction was the price of doing the paperwork. They made NO attempt to even assess what the bank was worth and they made no attempt to get a fair bid for it. (see a copy of the bidding info at www.wamucoup.com) Another illegal act --the FDIC is required to get the maximum they can for a seized bank...they did not (see the FDIC website).

The day we let the government agencies get away with illegal seizure, due to the fact that they are clueless about what is going on, and what a babks true financial picture is, is the day we all might as well move to Cuba!!!

The media has been quick to say that WAMU was managed badly...and indeed it was...but that is not the whole story about what happened to WAMU.

Investors who have bothered to do a little research know that, and that is why financials are not going to recover until this broken system is fixed. The government cannot seize an institution based on "what if" ... and the FDIC cannot give it away either...they are required to get a fair price, but they did not even try to do that. Please get the facts, and then judge what needs to be done. But get the facts first!!!

WAMU investors are now trying to work together @ www.wamuequity.org to be represented in the Chapter 11 proceedings. If you own WMI stock, we have not lost the war...yet...register your shares and work with us to get justice.

I read HRoller's article... very interesting, especially how the government used that loophole in WaMu's corporate structure to steal the bank and "save the economy" by screwing WaMu's equity and debt holders.. Who can doubt any form of collusion was involved, when WaMu corporate had enough cash on hand to more than double JPM's bid!! I don't know if this is true, but if it is what is the answer?? Was it that they didn't want to throw more money behind bad management?? Hello??? What does this tell us? Let's keep throwing tax money at these corrupt bankers, good idea!!

Sending report...

Chuck Saletta has been a regular Fool contributor since 2004. His investing style has been inspired by Benjamin Graham's Value Investing strategy. Chuck also can be found on the "Inside Value" discussion boards as a Home Fool.